Liquidity Pools

What is a Liquidity Pool?
When one token or coin is traded for another on a Decentralized Exchange (DEX), the trade is facilitated by a Liquidity Pool (LP). Volunteers, known as liquidity providers, pair a token with a native coin of a blockchain to allow other traders to buy or sell the token or coin. For example, if a trader wanted to receive a token on the Ethereum blockchain and the liquidity pair exists on the DEX, the transaction would send ETH to the liquidity pool, and the trader would receive the token from the same liquidity pool. Conversely, if the trader wanted to sell the token, the transaction would send the token to the liquidity pool, and the trader would receive ETH from the liquidity pool. Liquidity providers receive a share of the fees and coins or tokens sent to the liquidity pool, proportional to the share of tokens and coins they provide.

How are LP Prices Determined?
The DEX uses an Automated Market Maker (AMM) algorithm to ensure the prices of the tokens in the liquidity pool remain aligned with the market price of the particular token. However, since asset prices can fluctuate rapidly, the DEX allows traders to set a slippage percent, which is the maximum price percent difference the trader is willing to tolerate. If the price of the token or coin fluctuates outside of the established slippage percent, the transaction will fail.

What is Impermanent Loss?
Impermanent loss occurs when the value of the assets deposited in a liquidity pool decreases compared to their value when they were deposited. For example, if $1000 worth of PAW and $1000 worth of ETH were deposited in a PAW/ETH liquidity pool, and the value of ETH dropped to $800 while the value of PAW dropped to $900, there would be an impermanent loss of $300. It is called impermanent because the value of each asset has the potential to regain its original value.